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Executives

Barry Sievert, IR

Gregg Engles, Chairman and CEO

Jack Callahan, Jr., EVP and CFO

Analysts

Judy Hong - Goldman Sachs

Eric Serotta - Wells Fargo Securities

Terry Bivens - JPMorgan

Farha Aslam - Stephens Inc.

Alexia Howard - Sanford Bernstein

Christine McCracken - Cleveland Research

David Palmer - UBS

Jon Feeney - Janney

John Baumgartner - Telsey Advisory Group

Dean Foods Co. (DF) Q3 2010 Earnings Call November 9, 2010 9:30 PM ET

Operator

Good morning and welcome to the Dean Foods Company third quarter 2010 earnings conference call. Please note that today’s call is being recorded and it is also being broadcast live over the Internet on the Dean Foods corporate website. This broadcast is the property of Dean Foods. Redistribution, retransmission or rebroadcast of this call in any form without the express written consent of the company is strictly prohibited.

At this time, I would like to turn the call over for opening remarks to the Vice President of Investor Relations, Mr. Barry Sievert. Please go ahead, sir.

Barry Sievert

Thank you, Jamie, and good morning, everyone. Thanks for joining us for our third quarter 2010 conference call. We issued an earnings release this morning, which is available on our website at deanfoods.com. The release is also filed as an exhibit to a Form 8-K available on the SEC’s website at sec.gov. Also available during this call at the Dean Foods website is a slide presentation, which accompanies today’s prepared remarks.

A replay of today’s call, along with the slide presentation, will be available on our website beginning this afternoon. The earnings per share, operating income and interest expense information that will be provided today are from continuing operations and have been adjusted to exclude the expenses related to facility closings and reorganization, expenses related to closed and expected to close acquisitions, and other nonrecurring items in order to enable you to make a meaningful evaluation of our operating performance between periods.

The earnings release contains a more detailed discussion of the reasons why these items are excluded from the consolidated results, along with reconciliations between GAAP and adjusted earnings and between net cash flow from continuing operations and free cash flow from continuing operations.

We would also like to advise you that all forward-looking statements made on today’s call are intended to fall within the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. These statements will include, among others, disclosure of earnings targets, as well as expectations regarding our branding initiatives, expected cost savings, coverage ratios and various other aspects of our business. These statements involve risks and uncertainties that may cause actual results to differ materially from the statements made on today’s conference call. Information concerning those risks is contained in the company’s periodic reports on Forms 10-K and 10-Q and in today’s press release.

Participating with me in the prepared section of today’s call are Gregg Engles, our Chairman and CEO; and Jack Callahan, our Chief Financial Officer. Also joining the call today for the question-and-answer portion is Joe Scalzo, our President and Chief Operating Officer.

Gregg will start us off by providing a general review of the quarter, walking through the performance of the operating units and offering some commentary on the forward outlook. Following Gregg, Jack will offer additional comments on our financial performance before turning the call back to Gregg for some additional commentary on the balance sheet and other closing commentary. We will then open the call to your questions.

With that, I will now turn the call over to Gregg for his opening remarks. Gregg?

Gregg Engles

Thank you, Barry, and thank you all for joining us on today’s call. As you have seen this morning, we reported third quarter net income of $23 million, or $0.13 per share. These results are clearly disappointing and reflect continued significant challenges in our largest business, Fresh Dairy Direct-Morningstar.

Despite our poor consolidated performance, WhiteWave-Alpro continued to perform exceptionally well and delivered significant top and bottom-line growth. However, given the relative size of the business, it was not enough to offset weakness in the much larger Fresh Dairy Direct-Morningstar segment. As we’ve noted on previous calls, our core dairy business’ performance has suffered material margin pressure from the fundamental adverse shifts in the market pricing of private label milk and its related fallout.

More recently, two other factors have impacted our business. We have experienced weakness in milk category volumes and other beverage and cultured product categories within Fresh Dairy Direct-Morningstar. Butterfat costs also spiked to unexpectedly high levels in Q3, which further compressed segment operating performance.

In light of these results, we continue to take aggressive steps to improve our results at FDD-Morningstar, including accelerated cost reductions and, as we recently announced a realignment of the management and organization of the business. With that overview, let me drill down a bit into each of the businesses starting with Fresh Dairy Direct-Morningstar.

Fresh Dairy Direct-Morningstar gross profits declined $44 million from the year-ago period. While the issues impacting results are much the same as we’ve been dealing with for the past year or so, the relative magnitude has changed a bit. The pricing pressures on the core dairy business that began last year continued through the third quarter.

To attract customers in a tough climate, retailers have priced gallons of private label milk at deep discounts. The margin over milk metric on the right of this chart that tracks the spread between retail pricing of private label gallons of milk and the government-mandated Class I mover price remains essentially unchanged from prior periods, $0.40 to $0.50 a gallon below historical levels.

This continues to impact the processing industry in two ways. First, it drives ongoing pricing pressure from processors, such as Dean, as retailers look to reduce their costs across the category. Volume-hungry competitors have bid aggressively for available business, and contact renegotiations have been widespread. So far we have successfully maintained and even grown our share. However, this competitive intensity has resulted in broad-based price concessions.

The result of this pressure on our P&L accounted for the lion’s share of the year-over-year decline in segment gross profits in the quarter. The heavy competition in the marketplace will likely continue to impact the processing industry profits for some time to come.

Second, deeply discounted retail prices for private label milk have widened gaps between our more profitable regional brands and private labels. Although the year-over-year impact has lessened, consumers looking for value have continued to trade down to private label, and our product mix continues to deteriorate as a result.

In addition to our challenges in the fluid milk category, we have begun to experience volume weakness across the balance of the Fresh Dairy Direct-Morningstar portfolio. These factors, combined with the impact of steep butterfat inflation in the quarter, drove our operating income dip this period.

In spite of continued aggressive private label pricing, volume weakness in the fluid milk category that we began to see in the second quarter continued through the third. Part of this weakness can be explained by very aggressive promotion and low milk prices in the year-ago period Q3 2009, during which retailer feature ads in the category were more than twice as abundant as and much more productive than this year.

But we also continue to see intra-month trends of declining volumes throughout each month, indicative of cash-strapped customers. It is clear that a significant segment of consumers are not just looking for value pricing, they are cutting back on purchases of even basic items. These trends have had a pronounced impact on the fluid milk category, which has slowed considerably.

Fluid milk volumes across IRI-measured channels were down more than 3.5% in the quarter from a year ago. Across all channels, total USDA fluid milk volumes declined approximately 1.6% in the quarter. Within this, our fluid milk volume growth has weakened from approximately 2% growth earlier in the year to essentially flat in the last two quarters.

We began the quarter with volume growth of over 1% in July, but volumes were down significantly in both August and September. We estimate that our competitors’ volumes have been down more than 2.5% for the year, exacerbating the competitive intensity in the marketplace. While all volumes have outperformed the balance of the industry for some time, as we lap the Heartland acquisition in early Q4, we believe our volume performance will likely converge with the overall market.

As I mentioned, outside the fluid milk category, our product volumes in the balance of the Fresh Dairy Direct-Morningstar portfolio have also experienced widespread softness, declining 6% in aggregate. Our other beverage products, including juice, tea and water, declined mid-single digits. Cultured products declined more than 10%. Creamers declined low single digits. And the ice cream category was also soft in the quarter. In total, Fresh Dairy Direct-Morningstar volumes declined 2% in the third quarter.

The negative effect of this volume softness was amplified by the dramatic increase in Class II butterfat costs in the quarter, which created additional pressure on gross profits. Class II butterfat averaged $2.12 per pound in the quarter, and increased 70% from the year-ago period and more than 25% above the second quarter. As a reminder, Class II butterfat is a key input in our creamer, cultured and ice cream products businesses, where the pass-through of changes in input costs is less efficient than fluid milk.

The continued gross margin pressure on the business, higher fuel costs and increased bad debt expenses all contributed to drive segment operating profit well below year-ago levels at $116 million. Without question, our best strategy to combat this continued P&L pressure is to relentlessly focus on permanently reducing structural costs. Our teams have made great progress on this initiative with $175 million in projected cost savings from the beginning of 2009 through the end of this year.

We’re committed to becoming a differentiated, low-cost operation and are accelerating our efforts toward achieving our goal of $300 million of cost savings by the end of 2011, year three of our original three to five year target. Following completion of our initial goal, we then expect to drive at least $100 million in additional costs from the business each year for the next three to five years.

We’ve driven progress on our cost initiatives in all of our targeted areas. Total head count in the Fresh Dairy Direct-Morningstar business is down more than 1,000 positions in 2010 alone. Better technology has enabled the reduction of nearly 500 delivery routes since the beginning of 2009. Over the same period, fuel usage is down 4%, despite acquisitions. We’ve closed five facilities over that time, including one this year. Improved purchasing has produced more than $28 million in annual procurement savings.

Going forward, we’re expanding on these efforts in additional areas like the G&A cost initiative we recently announced, which we expect to drive $30 million in annualized savings by the end of 2011. We are also targeting reductions in milk procurement costs through improved logistics and in-sourcing those activities where it makes sense.

You should also expect a material increase in our network optimization efforts over the coming years, as we drive cost out of our system through remaking our manufacturing network. Stated simply, accelerated cost reduction continues to be the number one priority for Fresh Dairy Direct-Morningstar. Creating a differentiated cost position is critical to the long-term success of the business. As a management team and as an organization, we are aligned on this priority with a number of initiatives focused on permanently reducing structural cost to stabilize and then rebuild the profitability of Fresh Dairy Direct-Morningstar.

In addition to reducing costs, we think we can achieve substantial benefits by attacking the marketplace in a more integrated manner. To that end, we recently announced key executive changes that realign our organizational structure; an approach that we believe will make us more nimble and enhance our go to market strategy. As many of you saw, we recently created the role of Chief Commercial Officer with Chris Sliva, who was previously the President of our Morningstar division, assuming this post.

Chris will have responsibility for directing the commercial strategy of both the Fresh Dairy Direct and Morningstar divisions. This move is consistent with a broader initiative to tighten the alignment of the company’s sales organization, commercial lines of business and customer relationships, providing greater visibility, flexibility, efficiency and accountability. This is the first step in removing many of the artificial barriers that have historically existed between these two highly related businesses. Our goal is to go to customers with one Dean Face and to act that way all the way through the supply chain.

Let me now turn to our other segment, WhiteWave-Alpro. In contrast to our results at FDD-Morningstar, our WhiteWave-Alpro branded segment continued its strong momentum in the third quarter, driven by solid top-line sales. Third quarter segment net sales increased 8% over last year to $478 million, reflecting broad growth across the portfolio. Consistent with the first two quarters of this year, all of our key brands continued to drive solid volume-led sales growth in the quarter. Horizon Organic milk had an especially strong quarter, with growth in the high teens driven by our differentiated product offerings and continued solid category growth. Horizon has continued to outperform the category and gain additional share.

Our creamers business, led by International Delight, also continued to post strong growth. International Delight sales increased in the low double digits and market share continued to expand on the strength of continued strong category growth, our CoffeeHouse Inspiration innovations and strong base business. Our new, more indulgent Breve products are hitting the shelves now, and we look forward to continued strong innovation-led growth behind this launch.

Also in the quarter, our more traditional Land O’Lakes creamer sales grew in the mid-single digits. Our plant-based beverage businesses of Silk and Alpro continued to perform well on the strength of our new Silk PureAlmond product. Overall, Silk net sales increased in the mid-single digits. The introduction of Silk PureAlmond has been a clear success, as almond-based beverages now account for more than a quarter of the plant-based beverage category. And PureAlmond’s share within this segment is approaching 50%.

We plan to continue to innovate in the category with additional products in 2011. Alpro volumes and sales in the quarter increased high single digits on a constant-currency basis and were roughly flat after currency translation. This healthy growth across the top-line drove 10% growth in segment operating income to $39 million. Flow-through from the top-line was strong, but would have been stronger if not for mounting production capacity constraints in the business that are driving increased outsourcing of manufacturing and higher distribution expenses.

As we look ahead, we will address these constraints by spending capital to increase production capacity at WhiteWave. Overall, the strength of our branded business continues. We expect a solid finish to the year in this business and continued momentum as we look ahead to the next.

Before turning the call over to Jack to discuss corporate items, I’d like to first comment on our outlook. Looking at Fresh Dairy Direct-Morningstar, in the near term we expect this business to remain challenged as the retail environment continues to be very competitive and volumes across much of the portfolio remain soft. We expect a continuation of these pressures through the fourth quarter and into next year. Price concessions that have already been given will continue to impact year-over-year comparisons into 2011, regardless of whether we see a return to historical private label retail pricing levels or not.

As I mentioned, in order to offset these concessions, we will continue to intensely focus on our cost reduction efforts. I am confident that in time we will be able to get in front of the cost price squeeze in a way that will be difficult for our competitors to follow.

At WhiteWave-Alpro we expect the strong performance we’ve seen all year to continue through the fourth quarter when our creamer’s business typically does seasonally well. Given our run rate as we exited the third quarter and keeping in mind the typical strong seasonality of Q4, we expect fourth quarter earnings of between $0.13 and $0.18 per adjusted diluted share.

With that, I’ll turn the call over to Jack. Jack?

Jack Callahan, Jr.

Thanks, Gregg. Good morning, everyone. I’ll take a few minutes to walk through the consolidated financial performance in the quarter and discuss a few corporate items. Corporate expense of 53 million was essentially in line with year-ago levels and down a bit from the second quarter of this year. Headcount within the Corporate Center declined 5% in the quarter. And we expect head count to continue to decline over the next several quarters as we begin to roll out the G&A-focused portion of our cost reduction program.

Now let me turn to consolidated Dean results. With stronger WhiteWave-Alpro results offset by weakness at Fresh Dairy Direct-Morningstar, our consolidated gross profit declined $36 million from a year ago to 750 million. Below the gross profit line, total company operating expenses increased 18 million over the year-ago period.

Solid cost control was more than offset by the impact of higher fuel and freight costs across the business, especially at WhiteWave, in part due to the capacity constraints that Gregg just discussed. And this line was also impacted by the operating expenses related to the Heartland acquisition that was completed in the fourth quarter of 2009.

Total company G&A on an adjusted basis, which excludes the year-ago impact of deal fees, was down modestly. Driving operating costs leverage continues to be an area of focus going forward and a key to offsetting the margin pressures across the business.

In total, the heightened pressures on the Fresh Dairy Direct-Morningstar business more than offset our cost control progress and the strong growth at WhiteWave-Alpro, resulting in third quarter consolidated operating income that was 35% below year-ago results at 103 million.

Below the operating income line, interest expense increased $5 million from the year-ago period as a result of higher average interest rates related to the amendment and extension of our senior credit facilities earlier this year. Net income of 23 million drove third quarter adjusted diluted earnings per share of $0.13.

Now before turning the call back over to Gregg, I’d like to make one last comment. You may have seen the announcement this morning that I am leaving Dean in a couple of weeks for another opportunity. This was a very hard decision for me. Over the past four and a half years, the challenge of transforming Dean from a roll-up to a more integrated operating company has been exhilarating.

Today, the capability and plans are in place to accelerate structural cost reduction, realign our sales organization to ensure one face to the customer, and continue the growth of the WhiteWave-Alpro business, which is now almost $2 billion.

Overall, I am quite confident that this team will work through the current marketplace challenges and is building a much stronger Dean Foods. I know the Finance organization and its leadership team, now under Shaun Mara, is now well positioned to step up its contribution. I am committed to delivering as seamless a transition as possible.

With that, now let me turn the call back over to Gregg. Gregg?

Gregg Engles

Thanks, Jack. In spite of the recent challenges to our P&L, cash flows remain strong in our business. Net cash from continuing operations through the third quarter of this year was $379 million. Subtracting net capital expenditures of $180 million from this yields free cash flow of $199 million for the first nine months of this year. Since the completion of the Alpro acquisition in July of last year, we have generated $342 million in free cash flow, contributing to a significant reduction in debt since that time.

To further support the generation of free cash flow and our debt pay-down efforts, we continue to aggressively manage working capital. Our cash conversion cycle decreased approximately three days from the year-ago period, despite Class I milk and Class II butterfat prices averaging 50% and 70% higher, respectively, on a year-over-year basis. Total outstanding net debt at quarter-end stood at just under $4 billion, down $109 million from last quarter.

As expected, our leverage ratio of funded debt to EBITDA, as defined by our credit agreement, stepped up a bit this quarter despite continued debt reduction. This was due to the impact of reduced EBITDA in quarter three 2010 versus quarter three 2009. As of the end of the quarter, our leverage ratio stood at 4.9 times. We maintain strong liquidity with over $1.3 billion of currently available liquidity under our accounts receivable securitization and revolving credit facilities.

Earlier this year, we modified our covenant structure to allow more flexibility as we invest capital to drive our long-term strategies and weather the challenging economic and competitive environment. As a reminder, our revised leverage covenant ratio is 5.5 times. The covenant steps down to 5 times on June 30 of 2011. We are monitoring our covenant compliance closely and plan to continue to balance capital spending against our debt pay-down objectives to maintain appropriate flexibility.

Also, given recent results, we are evaluating options to further align our balance sheet with the strategic and investment needs of the business and to ensure adequate flexibility under our covenants. With this in mind, we expect capital spending of $300 million this year, reflecting spend on high return investments behind our strategic priorities to drive to absolute lowest costs in Fresh Dairy Direct-Morningstar, as well as initial investments in capacity to support the strong growth at WhiteWave-Alpro.

I want to reiterate our commitment to improving these results. Our industry is going through a wrenching ordeal. We’ve made solid progress on our cost agenda, but these ongoing pressures make it clear we need to accelerate our efforts, and we’re doing just that. We’re also working to build much needed capability, including the improvement of our pricing and forecasting capabilities to drive more predictability in our results. These things take time and we appreciate your patience.

I’m confident that we’ll be able to get ahead of these market pressures, competitively differentiate ourselves across several spectrums and return to strong earnings growth trajectory.

Before I wrap up, I also wanted to take a moment to comment on Jack’s upcoming departure. I want to publicly thank Jack for all of his contributions to Dean Foods. We’re a much more capable company today than when Jack arrived. He helped bring a new level of rigor to our organization, centralize much of Finance, and helped lead the strategic thinking that will drive our success in the future. He also conscientiously recruited and developed a deep bench of executive talent beneath him. Shaun Mara is a strong and capable leader, and we look forward to his contributions to the company as he takes the baton from Jack later this month. Thank you, Jack.

With that, I’d like to thank all of you for joining us today on the call, and ask the operator to open up the phones for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we’ll first hear from Judy Hong with Goldman Sachs.

Judy Hong - Goldman Sachs

Gregg, I guess I wanted to just understand the FDD profit shortfall in the quarter. And if I look at the pie chart where you went through the drivers of the profit decline, it looks like the private label margin got worse. Yet if I look at the year-over-year delta in terms of private label pricing over cost, you are facing much easier comps. So I guess I’m just trying to reconcile the two and really understand what really got worse in the third quarter from a private label perspective.

Gregg Engles

Well, it’s really two things. First of all, you have the ongoing effect of concessions that have been made from period to period in private label pricing, so the price between us and our customers. We continue to see downward pressure on pricing in the category and so you have an accumulation of lower prices as contracts have been renegotiated really over the last four or five quarters.

So that is clearly one impact. Another significant impact in driving lower profitability in the quarter is, frankly, we missed the volume here and we missed it pretty significantly. So through July of this year, or in July, we had volumes actually up about 1% period-over-period, but we saw very a significant fall off in volumes, particularly at retail, which is the most efficient gallon-oriented part of our business, where for the total quarter, volumes at retail ended up down almost 4%.

So we had a significantly de-levered manufacturing and distribution network over the back half of the quarter. And see some somewhat surprising softness in the category of fluid milk in the back half. So those are really the two big drivers as it relates to gallons of milk.

The other factor that gets embedded in our FDD-Morningstar results that really doesn’t get disaggregated is that about two-thirds of our business is liquid milk. The other third is largely comprised of Class II items, whether those are ice cream, cultured products, creams and creamers. And there we had a very significant spike-up in the cost of raw materials throughout the third quarter that, frankly, resulted in somewhere on the order of $0.04 of unanticipated costs $0.04 net of earnings per share in our Class II businesses during the period. So those are really the big items.

Judy Hong - Goldman Sachs

And then if I can just follow up on the private label side, so as you think about the trade-off between really going after these contracts that are being bid at lower prices versus walking away from some of these contracts, what’s the trade-off? Is the volume de-leverage really the issue here in terms of if you don’t win these, you do get hit on the volume de-leverage side? And then as we think about the Class I movers spiking up in the last couple of months, has that impacted the pricing concessions that you’re seeing in any way?

Gregg Engles

As to the first issue, you’re basically on the right theme here, right. We’ve got 100 manufacturing plants in the FDD-Morningstar network, rough numbers. And if you start walking away from meaningful amounts of volume, you’re going to have a lot of stranded fixed cost in the business. So we need the volume that we’ve got in order to successfully pursue and complete this transformation agenda we have of getting structural cost out of the business. And the fact of the matter remains that, while we’re not making as much, we’re still making money in the volume that we’re retaining.

So we’re not retaining this money at loss making margins or this volume. We’re retaining it at smaller profit margins. So the industry is going through a big shake out, and it’s I think the die is cast. It’s got to go through this shake out in order for it to return to any level of sustainable healthy profitability and growth. And we’re going to lead the transformation of this industry, and in order to do so, I think you’ll see us hold our share.

Judy Hong - Goldman Sachs

Okay, and then just the Class I movers spiking up and the impact on the fourth quarter, and as you think about the margin pressure that you could continue to see from higher Class I mover costs?

Gregg Engles

Yeah, it is always worse when it’s going up than when it’s going down. So the pass-through is not perfect. We’re going to experience some compression as we go through this period of rising prices, and you see that reflected in our guidance for Q4.

Operator

We’ll now hear from Eric Serotta with Wells Fargo Securities.

Eric Serotta - Wells Fargo Securities

I’m wondering whether you could comment on potential asset sales or spin-offs. Certainly there is a lot of value in your branded division. It doesn’t seem to be recognized in the current share price. On the other hand, it seems like some of the actions that you’re taking from an operating standpoint seem to be more integrating the two businesses together. So I guess the question is what direction are you going with the two businesses? And if the answer is towards further integration, why and how do you justify that given the valuations?

Gregg Engles

Yeah, first of all, let me just clear up the point of greatest confusion in your question. We are not further integrating WhiteWave with FDD-Morningstar. My commentary around organizational structure is that we are further integrating FDD and Morningstar, which reside within the same segment.

So apparently that wasn’t clear enough in our prepared comments, but we have quite separate businesses between WhiteWave and Alpro. And it’s important that we maintain quite separate businesses for lots of reasons. First of all, they are quite different. And secondly, to your point, perfectly appropriately, it allows us to maintain strategic flexibility to make decisions in the future that will maximize value for our shareholders.

So I would just point out a couple of things with respect to the WhiteWave-Alpro portion of your comments. First of all, trust me, we get it where the values are in the business and we have a pretty keen sense of whether or not WhiteWave-Alpro is adequately reflected in our valuation. So we understand those dynamics. But I would also point out that to the extent we are creating value over time and driving operating income growth and ultimately value creation in our share price, it’s happening in WhiteWave-Alpro today as opposed to FDD-Morningstar.

So for the long-term benefit of our current shareholders owning WhiteWave-Alpro is a value creating mechanism. The third thing I would point out is that these sorts of corporate structural activities that you allude to often come with a host of other costs and complexities that aren’t readily apparent on the surface. So for the time being, WhiteWave-Alpro is an important value creating asset within the portfolio of Dean Foods. It is managed quite separately and is separable, and we are keenly aware of all of the valuation issues that you’re discussing.

Operator

We’ll now hear from Terry Bivens with JPMorgan.

Terry Bivens - JPMorgan

Gregg, just one more thing on WhiteWave. I think you were pretty clear on that, but through the sweep of your career, you’ve certainly been about value creation. As we look at WhiteWave, I recall early on you seemed to think this thing could maintain a packaged food mid-teens kind of margin. Do you still have that view here?

Gregg Engles

Absolutely. The only wild card in that equation for WhiteWave-Alpro is the margin structure in Horizon Organic, while it’s growing close to 20%, the margin structure is more a conventional sort of milk margin structure. But if you disaggregate that, the rest of this business produces world-class consumer packaged goods margins. So in totality, it’s producing 10% operating income margins, and that’s with a $500 million plus Horizon business embedded within it. This is a fantastic both growth and margin business in the segment.

Jack Callahan, Jr.

Yeah, and this year margins have been muted a bit with the success of Silk Almond, so that until we internalize that volume, like any innovative product, it’s not going to carry the same base margin as the soy product, but that will improve over time. So there is also a little bit of mix that’s flowing through here that will improve as we internalize the volume.

Terry Bivens - JPMorgan

Understood. And this clearly is a theoretical question, but in the event you did decide that value creation is the way to go with WhiteWave, let’s say a spin, for example, would it theoretically be possible to affect that spin and put Horizon Organic into the big fresh milk division, or is that unrealistic?

Gregg Engles

Somebody early on in my career, Terry, told me not to answer too many theoretical questions.

Terry Bivens - JPMorgan

That was me, I think.

Gregg Engles

I’m just going to pass on that one.

Terry Bivens - JPMorgan

I mean, traditionally we’ve always known you to be a net seller of butterfat, but I guess judging from your remarks, the trajectory of Class II within the quarter overwhelmed the higher intake of you selling butterfat. Is that the right way to look at that?

Gregg Engles

Yeah, and, Terry, there was another dynamic that was important for us in the third quarter that, frankly, was really unusual in this third quarter. I mentioned to you that volumes in our milk business in the back half of the quarter were down significantly.

Terry Bivens - JPMorgan

Yeah.

Gregg Engles

Well, when our milk volumes are down, our production of butterfat is down, right, because we’re skimming butterfat out of milk that we sell. So we produced meaningfully less butterfat in Q3 than we had planned, so we bought much more butterfat outside the business.

Terry Bivens - JPMorgan

At much higher prices.

Gregg Engles

On at much higher prices. And on top of that, we had this very, very hot summer in the United States. And in hot weather, cows drink a lot of milk and they produce less butterfat per gallon. So the butterfat content of the milk that we received was lower than typical. So that drove really the spike in butterfat was less availability of fat throughout the marketplace and we had a double whammy of fat production internally. So it was a little bit of an odd anomalous Q3 as it related to butterfat that really drove our costs up.

Operator

Next we will hear from Farha Aslam with Stephens Inc.

Farha Aslam - Stephens Inc.

A question about next year. Milk curves and dairy curves look extremely attractive for Dean Foods next year. Do you think that you’ll be able to keep some of the benefit from lower commodities, or do you think with your new pricing contracts you’re going to have to pass most of that on?

Gregg Engles

Well, first of all, when we look out at 2011, we actually think 2011 is going to look a lot like 2010 in terms of milk. So first half pretty steadily declining mover followed by pretty significant escalation back up to around these levels at year-end. So just for a working hypothesis at this point in time, we think the mover in 2011 looks a lot like the mover in 2010. So it may well be a tale of two halves. Again, just the way the pricing mechanisms work here, we do better when the price is falling, because there is just some lag in the business and we suffer a little bit on the back half as the price rises. So we’ll get some benefit, as we always do in a falling commodity environment, in the first half of 2011.

On the other hand, we are working hard as a business in order to make our pass-through even better, right. So we would happily forego the margin accretion that we get on the downside in order to not suffer the compression on the upside. So it’s a pretty complicated process and it requires a lot of coordination with your customers and some different ways of thinking about pricing in this category, but we would like to remove as much of that lag and drag from the business as possible. So you may start to see some of that the benefits of that work as we go through 2011. But I think we’ll benefit from a falling commodity price in the first half of the year.

Farha Aslam - Stephens Inc.

So when you look at the businesses that you could potentially separate to create value, etcetera, do you have to focus on cash flow and debt service as you’re thinking about it because those are the businesses that are doing the best in WhiteWave are the ones that are providing the cash for debt service because the milk business seems to be taking a lot of cash and CapEx. How do you think about that as you’re going through and evaluating M&A?

Gregg Engles

Well, both of these businesses are net cash generating businesses. Next year, both Jack and I alluded to the fact that we’ve got to put some capacity on the ground in order to continue to grow our creamers business and in order to internalize our almond business in the company. And frankly, just as the rest of our business continues to grow, we are due to add another facility. So WhiteWave is going to get a lot of capital spending in 2011. And the milk business will get the same level of capital spending, slightly more than it got in 2010. But again, both of these businesses are significant net cash generators.

Your underlying question, as we think about our strategic options, yes, our balance sheet plays a role in the definition of what those options are and how feasible they are. So the balance sheet is an issue as you think through whatever value creating corporate organizational moves you might make.

Jack Callahan, Jr.

Just simply, WhiteWave very much helps us insulate any of the volatility that we see across the FDD-Morningstar business, so you would just that helps us manage the higher debt load that we have right now, without WhiteWave we’d be a much less levered company.

Operator

Next we will hear from Alexia Howard with Sanford Bernstein.

Alexia Howard - Sanford Bernstein

Two quick ones, I was wondering if you could give us a little bit more information about the outlook on the volumes? I think you mentioned that volumes at retail were down about 4%, I am wondering if that was something to do with the fact that retailers were using milk as a loss leader at this time last year and into the first half of this year and does that mean we’re going to be up against very, very tough comps and so the volume outlook looks challenged for a few quarters here?

Joseph Scalzo

Alexia, I think this is Joe Scalzo; I think that’s a fair assessment as to how we see it. If you look at the year-ago period in the third quarter and fourth quarter, milk was both very aggressively priced as well as very aggressively promoted, lots of feature activity, deep feature prices. And because it was early in this recessionary cycle of deep discounting milk, you saw really good promotional lifts off of that. So we’re going to be lapping that for a while and that will hold, especially in retail, volumes down for a bit, so that’s clearly reflected in our go forward outlook.

Gregg Engles

I think that is compounded, Alexia, by the fact that year-over-year ‘09 to 2010, the mover is also up 50%. So you had really low mover, so low base prices and heavy promotion last year. This year less promotion, a mover up $5 a hundredweight so.

Alexia Howard - Sanford Bernstein

That’s great. And then just a quick follow-up, I know we’ve talked about excess industry capacity quite a bit over the last year. Do you have any estimation about how big that is right now and how much you’ve seen come out of the industry over the last few months as things have got challenging?

Gregg Engles

It’s really hard to put a number on how much excess capacity exists out there because most of these companies are private companies, and it’s hard to see into our capacity as well if you’re not in the company. So, but I would say there is enough to have caused very significant price compression as we’ve moved into this recession with a very aggressive customer base on price. We do see signs that people are recognizing that they need less capacity in their own businesses. So we see industry volumes down 1.5% to 2%.

If you just look at our FDD milk business, we’ve got 100 plants. That means that net-net as that volume’s gone out, I’ve idled two entire facilities that I just don’t need in this lower volume environment and I’ve been taking share. So if the rest of the industry has 300 plants out there among the rest of the fluid milk segment and they’re down 3% or 4% in terms of fluid milk volumes, then there is 10 to 12 plants that’s been idled just by the decrease in volume and there was other additional capacity when we went into this thing.

So there is plenty of idle capacity out there that needs to come out and we’re seeing the signs that people are coming to grips with the fact that this situation is not going to abate like it has in the recent past and people need to get their capacities right. So we’re hopeful in that regard. We’re certainly going to do what we need to do to get our capacities right.

Operator

We will now hear from Christine McCracken with Cleveland Research.

Christine McCracken - Cleveland Research

I just wanted to dive a little bit more into your outlook for dairy costs into the balance of the year and ‘11. I think, Gregg, you mentioned some of the issues that drove butter prices up during third quarter certainly impacted your margins there on your current business. I’m just wondering it seems like a lot of those issues were more temporary. It seems like some of those would normalize once you get past the holidays. I’m just wondering why you wouldn’t expect maybe a little less pressure on the butter side as we head into ‘11?

Gregg Engles

Well, we were talking about the Class I mover. We will see an abatement in butter. We’ve already saw it. Butter cracked pretty hard at the end of last week. It was down $0.27. It bounced up a little bit yesterday. We’ll see where it settles out, but butter was a little bit overdone in terms of price. It’s going to come down as we move through the first part of next year. Cheese is starting to move down, so we fully expect the mover to come down the Class I mover, driven by both fat and skim, through the next say, five to six months. Then we expect it to bottom. This is our preliminary view sometime in Q2 of next year and start heading back up to around these same levels. So that’s the overall view of the Class I mover from where we sit today going forward. So, yes, we do expect it to come down in the first half of next year.

Christine McCracken - Cleveland Research

And your expectations around second half to increase, is that driven by exports or a drop in supply? Is there something specific behind that, because it would be difficult I think, to anticipate some kind of weather event?

Gregg Engles

Yeah, we’re not, no, trust me, we’re not prognosticating weather in April or May next year, trust me. No, I think the primary logic train there is that you’re seeing significant increases in input costs for farmers, right. So you’re seeing the grain complexes because of the global markets and quantitative easing, growth in the emerging or recently emerged marketplaces, putting upward pressure on grain supplies. Most of the cows in the US are fed, not grazed, so farmers’ costs are increasing significantly. And as opposed to maybe the last cycle like this in ‘07,’08, you have farmer balance sheets in much worse condition than they were going into ‘07. So the logic train is capacity comes out on the farm side much more quickly this time than it did last time and that drives a more rapid rebound in the cost of milk in the back half of 2011. That’s the logic.

Christine McCracken - Cleveland Research

All right. And then just on those commodity prices, as you look at soybean prices up pretty significantly, obviously you guys use food grain, but is there any commodity cost concern on your soybean business given the jump in commodity costs there?

Gregg Engles

Yeah, we’re not like unlike anybody else in the food space. At WhiteWave-Alpro, we are experiencing significant commodity inflation across our portfolio.

Jack Callahan, Jr.

It’s not just soybeans. It is also sugar and palm oil.

Gregg Engles

Palm oil, it is everything we use in the agricultural complex.

Christine McCracken - Cleveland Research

So given the competitive conditions, I guess, then as you look at pricing moving forward, do you feel comfortable being able to raise prices in the current economic environment, maybe especially now that milk prices are coming up might give you a little bit of room to increase prices on your non-milk portfolio?

Gregg Engles

Yeah, I think the dynamics in WhiteWave-Alpro are just very different. First of all, you have surging volumes there. So our volumes this year in that business will be up high single digits to close to double-digits in the business across the portfolio and we have very strong share positions in almost all of those categories. And I think all of the people that we compete with in those spaces are going to be taking price. So, I mean, you heard Sara Lee come out this morning saying, hey, we’ve got lots of commodity inflation. We’re going to be out there taking price and they’re just the last of a long line of folks who’ve said that. So that will be we’re going to have to take some price to maintain our profitability at WhiteWave-Alpro. And we believe in that segment of the industry the dynamics are much more favorable to taking price than they are in liquid milk.

Christine McCracken - Cleveland Research

Fair enough and just one final question, you’ve had a number of senior level management changes here over the last year or so. I’m just wondering as you look forward and your strategy it seems very consistent I think, with what you have been telling us. I’m just wondering are you comfortable with the current management team you have in place, and if there’d be any kind of rethink on your strategy given some of this high-level turnover?

Gregg Engles

Christine, we are absolutely committed to the strategy we’re on. We believe it’s not only the right strategy but, frankly, the only sensible long-term strategy for the category and for this business. And we have a very, very sound team that we’ve built over the last five years. You’re seeing some natural evolution in the team as executives reach different parts of their career and, frankly, experience some natural fatigue of going through a very, very difficult environment here for the last three or four years.

And I think it’s a credit to the leadership of the business that we have built such a strong bench here that most of the evolution of our management team is happening internally. So these are not unexpected moves in a business of our size and scope in undergoing a wrenching transformation. And we’ve got a great stable of talent in the house to continue to drive forward on our strategy.

Operator

We’ll next hear from David Palmer from UBS.

David Palmer - UBS

Morning. A big picture question here, is the compressed margin environment, really as you look at it, simply a result of one, two, three large-scale food retailers having a strategy to use private label as a loss leader, foot traffic driver? And/or is this also perhaps partly a result of more aggressive behavior from other dairies under new ownership, and we’ve seen some structure changes in terms of who you’re competing with out there? Could you perhaps comment on that? And to the degree that other dairies had been more aggressive, is it becoming less clear to Dean that you guys have the low cost advantage that we would think that you would have versus your competition? I’d love your thoughts. Thanks.

Gregg Engles

Yeah, none of these things are totally black and white. How I would characterize it is that this ball got rolling down the hill with lots of energy as a result of changes in the retail environment. So a recession, consumers seeking value, retailers thinking to show value to their customers with key value items and, as it often does, it starts with a few big retailers or a few new entrants, and we have some of each of those in the grocery category that get things moving downhill. So when they get moving downhill, then there are collateral effects. And so as the retail price environment deteriorated, you get responses from the entire retail community now trying to stay in value and match. And then you get a price pressure back up the supply chain with retailers looking for help in funding this strategy.

So in that environment you get a bit of a churning of the pot in which the buying community, the retail community, is leveraging the excess capacity that exists. And it exists throughout everybody’s network. And now manufacturers, back to Judy Hong’s point, start focusing on the fact that they’ve got fixed cost infrastructure that they’ve got to cover and they compete to retain volume. So that’s the basic dynamic.

It started with the retail environment, and its rippled back into the processor environment. We really don’t see even with these changes in ownership of other processors, we don’t see people actively seeking to grow their share, right. People are trying to hold volume in their facilities, and in a declining category, ultimately that means growing share a little bit, because there is less volume for everybody. So if you want to hold your volume, you’ve got to take a little share. But we don’t see people actively initiating lower pricing around the environment. It’s more responsive. That’s not to say it doesn’t happen at all. Again, it’s not black and white.

But these plants are in fixed geographies and they can serve fixed markets and customer bases, and people maybe look a little farther afield from their plants. But I think the processing industry is in a very reactive mode right now.

Joseph Scalzo

And to answer your question on our position, cost position relative to the marketplace, we are better than we were three, four years ago. Not as good as we need to be in order to have a sustainable cost advantage in the market. And that’s the basis for all of Gregg’s comment earlier on attacking our supply chain, permanently removing structural costs and getting into a position that is very difficult for the competition to beat.

David Palmer - UBS

In the last couple of quarters, have you even passed what you said originally made some additional cutting cost efforts? I mean, is there any numbers you can talk about in terms of how much bigger your targets are getting in terms of cost cutting?

Gregg Engles

I think what we have said really clearly is, we’re going to hit this $300 million in three years and then for the next three to five years, we’re going to put another $100 million per year on top of that. So we’ve been running at $100 million a year pace and we’re going to keep that up for a total of six to eight years from the beginning of this process in 2009.

So we’re on a path to hack a massive amount of cost out of this organization. And just as evidence of that, I think this is actually quite a remarkable number. In the first nine months of this year, we’ve taken a net over 1,000 head count out of our FDD-Morningstar business. That’s a huge number and we’ve got a lot of costs still to take out of these businesses.

Joseph Scalzo

If you want to translate what that means, it means fewer facilities, fewer routes and fewer people in our organization as we go forward, right. That is the structural cost that has inherent inefficiency in it as we move to the supply chain that we’re going to have on a go forward basis in the future.

Operator

We’ll now hear from Jon Feeney with Janney.

Jon Feeney - Janney

Hey, Gregg, I wanted to just go out with a little bit more specificity on something a couple of people have asked about which is when are some of these competitors going to be forced to get more rational? When I compare this quarter in terms of operating profit per gallon to the only to the worst other one I have seen on record, which would have been Q2 ‘07 other than Q1 this year, Q2 ‘07. We’re about, by my estimates of what you’ve told us, like 4% in gallon growth whatever, we’re about 32% below in profit per gallon for you. If you take effect to the $36 million in quarterly cost savings you’d achieved as of last September with the 145 number you told us.

So when I think about that and then I think about the branded to private label mix that you suffered has to be much worse at these other regionals because they’re going to do a lot less private label business than you are, so they’re going to feel worse tradedown, if you will, whatever you want to call it, that impact of going from branded to private label profit. What’s the number? Where is it? These guys are not making a return on their assets and have you seen any, I mean forget about what you’re hearing in the marketplace. Has anybody filed? Has anybody liquidated? Is anybody getting out of the business that you’ve heard of in the industry?

Jack Callahan, Jr.

Yeah, I think the one thing, I think you’ve characterized the factors that would argue for some stabilization of processor pricing in the marketplace. I think you have to look at the flip side of the total profit pool as you look between retailers and processors and that is the size of the investment that retailers have made in this industry is the countering factor to keeping processors aggressive, right.

Retailers have made significant investments over the last 12 plus months in this business and they’re trying to recover some of that investment from processors. Processors are sitting with stranded fixed costs, so they’re doing whatever they can do to hold onto their volume. So they’re being very aggressive from a price standpoint in order to avoid further de-leverage.

So I think, as Gregg commented, people aren’t processors are not out trying to take other processor’s volumes. They are just trying to hold onto their own volume with retailers trying to extract concessions from the processor community. So that’s the countering force in the overall profitability drain in the processor industry, retailers still trying to recover some profit pool. I think when you start seeing that abate, when their investment starts becoming less, then you’ll see a little of the pressure taken off processors and I think you’ll see margins start to stabilize on the processor side of the business.

Gregg Engles

Yeah, and, Jonathan, to your when does the industry tip and have to shed capacity, this last year feels like about 10 years to me, and I’m sure it does to you guys that follow the industry. But I would remind you that one year ago on our call, we were talking about the third quarter of what was going to be our most profitable year ever.

Jon Feeney - Janney

Right.

Gregg Engles

And that is true for everybody in the industry, right. We just made a historically anomalously high amount of money. So everybody came into this with pretty full provisions and people are going to have to believe that this is the new normal, which I think you’re hearing us say we think it is and they’re going to have to experience it for a while before they look for a different course of action, right.

The industry has always gone through ups and downs. And the downs have always been followed within relatively short order by ups, usually driven by the commodity cycle. And I’m not sure everybody sees it the same way we do in terms of stressed consumers, much more aggressive retailers, and more well informed and educated retailers. And I’m not sure everybody perceives that the marketplace has changed as fundamentally as we believe that it’s changed. So until everybody comes to that conclusion, and they start running out of this money they’ve husbanded, I’m not sure that the world changes a lot. I think it’s going to be a while.

Jon Feeney - Janney

And it sounds to me, to summarize what you and Jack said, is you have it’s the two large retailers that are not significant customers of yours that seem to be what’s changed the margin in the industry, their view of profits relative to other benefits they might get from driving milk volume.

Gregg Engles

I don’t know if I could fairly characterize it that way. What I do really believe though, is that if they knew now what they knew then, they probably would not have gone down this path. Because whatever benefit they got from cheap milk prices, look at it, we got historically cheap margin over milk, and volumes in the grocery segment are down 4%. I mean that’s just not a winning strategy at retail. So, but it’s very hard to walk back from that in this kind of economy.

Jon Feeney - Janney

Just one detail question. I’m sorry if I missed it. Jack, are you at liberty to say where you’re going, and when will you be able to, if you can’t?

Jack Callahan, Jr.

It’ll be announced in the coming weeks.

Operator

Ladies and gentlemen, we have time for one more question. And we’ll take that from John Baumgartner with Telsey Advisory Group.

John Baumgartner - Telsey Advisory Group

Gregg, I think shifting to the WhiteWave here, specifically at Horizon, any view there on organic milk supplies in 2011 and where you’re sourcing costs might go?

Jack Callahan, Jr.

Yeah, as we have seen the volume, demand volume in the category pick up, it’s obviously starts to put a little bit of pressure back on the supply end of the business. So you’re going to see some pressure on farm, price to farmers, and Gregg already alluded to the fact that input costs are going to start going up. So I think you’re going to see a little pressure on pay price to farmers as we go forward right now. It doesn’t feel like there is a lack of supply. I don’t think we’re going to be supply constrained next year. I think it’s going to tighten up. And I think you’re going to see some cost pressure on pay price to farmers. But I don’t think we’re going to be in a situation where we get upside down between demand and supply.

John Baumgartner - Telsey Advisory Group

Okay, and then I guess thinking about conventional milk, and I guess just reconciling some of the USDA’s fluid milk category volume and the softness there with some of the milk, the raw milk production numbers coming out. I mean what is the difference there? Are we seeing a big mix shift as far as utilization goes into finished dairy products?

Gregg Engles

Yeah, John, the reality is and has been for a long time that only about 30% of milk production in the US goes to drinking milk, right. The other two-thirds go into cheese and butter and powder and ingredients and export. So it’s probably a commonly held misperception that drinking milk drives the category. It really doesn’t.

John Baumgartner - Telsey Advisory Group

Okay, and I guess just finally, maybe just following up on Eric’s question, can you talk a little bit about your thoughts on the ice cream business as a strategic component going forward? I’m just thinking about as you focus on the second phase of cost initiatives here, might the ice cream business be deemed a little bit less essential going forward, given your competitive position there?

Gregg Engles

The ice cream business is a business that we’re in primarily because we bought fluid milk businesses that were in it. So we never set out to build a strategic position in ice cream. On the other hand, it’s become a $900 million business for us, and so we have to think about it strategically. And it’s a business that has produced over time healthy profitability for us. We have some very good regionally branded positions in the business, but I think it’s a fair point to say that we have to sort out over time where we’re going with ice cream. Unlike WhiteWave, however, ice cream is pretty embedded in our fluid dairy business today, so the level of complexity in changing direction there is quite high.

Gregg Engles

Thank you all for joining us on the call this morning. We will look forward to talking to you in February when we report our full-year results. And in the meantime, I hope to see and have conversations with many of you and your clients over the coming weeks and months. Thank you.

Operator

Ladies and gentlemen, that does conclude our conference for today. We thank you for your participation.

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